Relief from UK services inflation seen fleeting

British inflation dipped to 2 percent in December – its lowest since November 2009 and within the Bank of England’s target. Part of the move was driven by a fall in prices in Britain’s services sector – which constitutes more than three quarters of the country’s output.

Services inflation, which makes up around 47 percent of the consumer price index, eased to 2.4 percent in December – also its lowest since November 2009. Goods inflation – which is more sensitive to global markets than domestically generated services inflation – edged up to 1.7 percent last month. But it has also come down in recent months as a strengthening sterling pushed down import prices.

The fall has helped the case for the Bank of England to keep interest rates at a record low of 0.5 percent, also giving the government a boost ahead of elections next year. Analysts say weak wage growth may be a reason for more subdued services inflation, but given the strength of the labor market, this trend could be fleeting.

According to Brian Hilliard, chief UK economist at Societe Generale:

“In the UK, we are a price taker … off the world market so our goods prices depend on world goods prices and exchange rates whereas, for services, it’s more determined by the state of the labour market and I think the labour market will actually firm up with this growth pulse that we are experiencing. So my forecast is that services inflation is close to bottoming out.”

He expected unit labour costs to accelerate as growth continues to be strong but productivity sluggish.

Sam Hill, UK economist, at RBC said the fall in services inflation was a reflection of weaker wage pressures in the economy and was significant given its importance for the overall index. Even though he expects inflation to rise from current levels, he still thinks it will be low enough to allow the Bank of England to keep interest rates at record lows.

“Given the stronger dynamics in the labour market, it would be unusual if wage growth remains quite as weak as it is currently but given that it is starting from such a low level, it does provide the Bank with room to keep policy loose in the near term.”

At 2 percent, British inflation is above that of all other members of the Group of Seven rich economies.

Data in December showed Britain’s unemployment rate falling to its lowest level in four-and-a-half years to 7.4 percent in the three months to October. Despite the fall in unemployment, many people in work are not seeing an improvement in living standards. Average weekly earnings growth excluding bonuses grew 0.8 percent, matching a record low and way below December’s inflation number.